ELECTRONIC SUPPLEMENT TO CHAPTER 11

Transcription

1 C H A P T E R 11 ELECTRONIC SUPPLEMENT TO CHAPTER 11 CONSOLIDATION UNDER A CURRENT COST SYSTEM Many of the differences between the parent company, entity, and contemporary theories of consolidation arise because we do not record value changes in the accounts of affiliated companies as they occur. Although entity theory intends to provide a consistent valuation approach for majority and minority interests, it does not accomplish its objective because the net assets of the parent company are not revalued at the time of acquisition and because no revaluations occur after the date of a business combination. This supplement provides a brief digression from generally accepted accounting principles in order to consider how the consolidation process might be altered if GAAP were to adopt a current cost approach. Conceivably, the adoption of a current cost system would eliminate many of the inconsistencies and complexities that arise in the preparation of consolidated financial statements. Current Cost Accounting U.S. companies may supplement their financial statements with current cost information as specified in FASB Statement No This supplementary information includes current cost of inventories, property, plant, and equipment, and the effect on income from continuing operations of measuring cost of sales and depreciation on a current cost basis. Authoritative accounting bodies do not require business enterprises to issue current cost financial statements, so this section is limited to examining possible changes that a current cost system would have on the preparation of consolidated financial statements. The discussion assumes that implementation of a current cost system would involve the revaluation of all identifiable assets and liabilities on a current cost basis at each statement date, and that unidentifiable assets (that is, goodwill) would continue to be recorded on a cost basis. 2 We assume all changes in current costs of identifiable assets and liabilities to be included in the measurement of net income in the period of change. Also, we measure goodwill or negative goodwill by the difference between the purchase price and the current cost of net assets acquired. Under these assumptions, many of the problem areas of consolidations could conceivably be avoided. 1 FASB Statement No. 33, which required certain large companies to disclose current cost information, was superseded by FASB Statement No. 89 in December Statement No. 89 encourages, but does not require, disclosure of supplementary current cost information. 2 Most current cost systems are not designed for the valuation of a business as a whole, but rather for the valuation of identifiable assets and liabilities. These systems record unidentifiable assets only where necessary to reflect the acquisitions of groups of assets or entire business enterprises. Once recorded, we do not adjust the accounts for unidentifiable assets for changes in current costs. Electronic Supplement to Chapter 11 1

2 We need few consolidation adjustments to consolidate the accounts of a parent company and its subsidiaries if all affiliates value their identifiable assets and liabilities on a current cost basis. We still eliminate reciprocal accounts, but the elimination process is greatly simplified. Reciprocal receivable and payable balances, including accounts for intercompany bond investments and bond liabilities, 3 should be precisely reciprocal under a current cost system, such that no income or equity accounts would be involved in the elimination process. Further, there are no constructive gains or losses on intercompany bond purchases because the purchase price of intercompany bonds is equivalent to the current cost of the liability at the time of its constructive retirement. Under the historical cost system of accounting, the basis of income recognition is the sale of goods and services to other entities. In such a system we defer all gains and losses on intercompany transfers until subsequent sale outside the consolidated entity. Because changes in current cost form the basis for income recognition under a current cost accounting system, there is no need for deferring recognition of gains and losses on intercompany transfers. We state the assets at their current costs, not their transfer prices, in both separate company and consolidated financial statements. Thus, under the current cost system assumed in this supplement, there are no unrealized gains or losses on intercompany purchase and sale transactions. This is because the basis for income recognition becomes changes in current cost, and we recognize any differences between intercompany transfer prices and current costs on the books of the purchasing affiliate during the period of the intercompany transactions. Investment in subsidiary and underlying subsidiary equity amounts under a current cost system should be reciprocal except for any unamortized excess of purchase price over the current cost of net assets acquired. In other words, the initial difference between investment cost and current value of net assets acquired would lie solely in the goodwill or negative goodwill associated with a purchase business combination. Minority interest computations under a current cost system would also be simplified. Income of minority stockholders under parent company or contemporary theory would be equal to the minority interest in subsidiary net income, and total minority interests at any date would be equal to the minority interest s share of the current cost of subsidiary net assets. Consolidation Procedures Under Current Cost Accounting Assume that Podunk Corporation acquires 80% of the outstanding stock of Sickle Corporation on January 2, 2003, in a purchase business combination. Balance sheets of the two companies on a current cost basis just before the combination are as follows (in thousands): Podunk Sickle Assets Cash $ 50 $ 20 Accounts receivable Inventories Plant assets net Total $900 $450 Liabilities and Equity Accounts payable $ 60 $ 30 9% bonds payable 100 Capital stock, $10 par Retained earnings Total $900 $450 The identifiable net assets of both Podunk and Sickle are fairly valued at their current costs and require no adjustment for purposes of the business combination. If Podunk issues 20,000 shares of stock with a market value of $400,000 for 80% of Sickle s outstanding shares, we record the investment as follows: 3 We determine current costs of bond liabilities and investments by references to market prices if current quotations are available. Otherwise, we determine them by imputing current interest rates and using present value computations. 2 ADVANCED ACCOUNTING

3 Investment in Sickle (+A) 400,000 Capital stock, $10 par (+SE) 200,000 Additional paid-in capital (+SE) 200,000 To record acquisition of an 80% interest in Sickle. A consolidated balance sheet for Podunk and Sickle immediately after acquisition shows goodwill of $144,000, equal to the excess of investment cost over current cost of net assets acquired [$400,000 ($320,000 80%)]. A consolidation working paper entry to consolidate the balance sheets of the two companies is: Capital stock Sickle ( SE) 300,000 Retained earnings Sickle ( SE) 20,000 Goodwill (+A) 144,000 Investment in Sickle ( A) 400,000 Minority interest (+L) 64,000 The consolidated balance sheet prepared on a current cost basis immediately after the business combination appears as follows: Podunk Corporation and Subsidiary Consolidated Balance Sheet at January 2, 2003 Assets Current Assets Cash $ 70 Accounts receivable 150 Inventories 330 Total current assets $ 550 Plant assets net 800 Goodwill 144 Total assets $1,494 Liabilities and Equity Liabilities: Accounts payable $ 90 9% bonds payable (at par value) 100 Total liabilities $ 190 Stockholders equity Capital stock, $10 par $ 700 Additional paid-in capital 200 Retained earnings 340 Majority interest 1,240 Minority interest 64 Total stockholders equity 1,304 Total liabilities and stockholders equity $1,494 Because we consolidate the identifiable assets and liabilities of both parent and subsidiary at their current costs, we value all assets and liabilities consistently except for goodwill, which relates only to the majority interest. Intercompany Sales of Inventory Items in a Current Cost System Assume that Podunk sells merchandise to Sickle for $20,000, that the merchandise was produced by Podunk during 2003 at a cost of $12,000, and that it had a current cost of $15,000 at the time of sale. Podunk realizes profit of $8,000 on the sale during 2003, regardless of whether Sickle resells the merchandise or inventories it at year end. However, if the goods have a current cost of $15,000 and remain unsold at year end, Sickle will decrease its income for 2003 in the amount of $5,000 by writing down the merchandise to its $15,000 year-end current cost. The entry on Sickle s books to record the write-down is: Cost of sales (E, SE) 5,000 Inventory ( A) 5,000 To reduce inventory to its current replacement cost at year end. Electronic Supplement to Chapter 11 3

4 Although a separate account to record the $5,000 loss on the write-down to current cost could have been used, we make the adjustment to cost of sales in order to keep the illustration basic. The net result of the intercompany sales transactions during 2003 increases the combined income of Podunk and Sickle by $3,000 an $8,000 increase by Podunk and a $5,000 decrease by Sickle. Consolidated net income for 2003 also increases $3,000 during 2003, not as a result of the intercompany sale, but because the consolidated entity held merchandise during 2003 while its current cost increased from $12,000 to $15,000. A consolidation working paper entry to consolidate the accounts of Podunk and Sickle for the year is necessary to eliminate intercompany purchases and sales as follows: Sales ( R, SE) 20,000 Cost of sales ( E, +SE) 20,000 To eliminate intercompany sales. We need this working paper elimination entry in order to show the correct operating results of the consolidated entity, but it has no effect on consolidated net income. Notice that we require no working paper entry to adjust the inventory. This is because the inventory is recorded on a current cost basis in the separate accounts of Sickle. A brief analysis of the separate company and consolidated income statement effect of the $20,000 intercompany sale may be helpful. Consider the following partial consolidated income statement working papers in terms of increases and decreases: Adjustments and Consolidated Podunk Sickle Eliminations Income Statement Sales $+20,000 $ $ 20,000 $ Cost of sales +12,000 +5,000 20,000 3,000 Gross profit $+ 8,000 $ 5,000 $+3,000 Separate company cost of sales consist of the $12,000 historical cost on Podunk s books and $5,000 on Sickle s books from adjusting the inventory from $20,000 to its $15,000 current cost. When we eliminate the intercompany sales and purchases through the working paper entry, the final effects decrease consolidated cost of sales by $3,000 and increase consolidated net income by $3,000. This $3,000 is simply the increase in the current cost of the goods produced by Podunk and held within the consolidated entity at December 31, Although some theorists would classify the $3,000 increase as a separate consolidated income statement item rather than as a reduction of consolidated cost of sales, this type of refinement does not seem necessary in view of the broad and general treatment accorded in this supplement. The previous discussion of the $20,000 downstream sale from Podunk to Sickle is equally applicable to an upstream sale by subsidiary to parent company. Intercompany Sales of Plant Assets in a Current Cost System Assume that Sickle owns land with a current cost of $8,000 on January 2, 2003, that it sells the land to Podunk for $10,000 during 2003, and that the land has a current cost of $8,500 at December 31, Under these assumptions, Sickle will record a $2,000 gain at the time of sale and Podunk will record a $1,500 loss at year end when it adjusts its land account to a current cost basis. Podunk will record the write-down to current cost as follows: Loss on adjustment of land to current cost (Lo, SE) 1,500 Land ( A) 1,500 To adjust the land account to its current cost at year end. The combined effect of the intercompany land sale increases income for 2003 by $500 a $2,000 gain to Sickle and a $1,500 loss to Podunk. These amounts are realized by Sickle and Podunk, respectively. For consolidated statement purposes, however, we include only the $500 net increase in consolidated net income. This $500 consists of the increase in the current cost of the 4 ADVANCED ACCOUNTING

5 land while it is being held within the consolidated entity (from $8,000 at the beginning of the year to $8,500 at year end). Podunk s books adjust the land to its current cost at year end, so the only working paper entry needed is as follows: Gain on land ( Ga, SE) 1,500 Loss on adjustment of land to current cost ( Lo, +SE) 1,500 To offset gain and loss at counts from intercompany sale of land. The $500 gain not eliminated is included in the consolidated income statement as the only income statement effect of the intercompany sale of land. By this time, you should have discovered that the effect of intercompany transactions on consolidated net income is determined by changes in the current cost of assets held within the consolidated entity, and not by transfer prices. 4 A $500 increase in consolidated income would have resulted if the intercompany sale had occurred at $7,000, $9,000, or some other amount. As in the case of inventory items, the gain could be reflected in the consolidated income statement in various ways. Constructive Retirement of Intercompany Bonds in a Current Cost System If Podunk acquires 50% of Sickle s outstanding bonds for $48,000 on December 31, 2003, there is no constructive gain on the bonds. This is because Sickle s bond liability on this date is $96,000 its current cost at December 31, 2003, as established by Podunk s purchase of 50% of the bonds for $48,000. On its separate books, Sickle Corporation will recognize a $4,000 gain for 2003 on the revaluation of its bond liability to a current cost basis. However, we consider this gain an adjustment of Sickle s bond interest expense for the year rather than a separate income statement item. We reflect the $4,000 decrease in Sickle s interest expense in Sickle s separate income statement and in the consolidated income statement for The only working paper entry necessary for the intercompany bond holdings is: 9% bonds payable ( L) 48,000 Investment in Sickle bonds ( A) 48,000 To eliminate reciprocal bond amounts. Now assume that Podunk purchases the bonds of Sickle on July 1, rather than on December 31, 2003, and that Podunk pays $47,000 for 50% of Sickle s bonds. Also assume that all adjustments to current cost are made at year end, at which time the current cost of the bonds is $96,000 ($48,000 for 50% of the bonds). Under these assumptions, Podunk and Sickle will make the following entries on their separate books during 2003: PODUNK S BOOKS July 1, 2003 Investment in Sickle bonds (+A) 47,000 Cash ( A) 47,000 To record bond investment. December 31, 2003 Cash (or accrued interest receivable) (+A) 2,250 Investment in Sickle bonds (+A) 1,000 Interest income (R, +SE) 3,250 To record nominal interest on Sickle bonds and to adjust interest income for a $1,000 increase in the current cost of the bonds. (Continued) 4 No gains or losses are deferred under the current cost system visualized in this supplement, so it makes no difference if the sales are upstream or downstream. Electronic Supplement to Chapter 11 5

6 SICKLE S BOOKS December 31, 2003 Interest expense (E, SE) 5,000 9% bonds payable ( L) 4,000 Cash (or accrued interest payable) ( A, +L) 9,000 To record nominal interest for the year and to adjust interest expense for the $4,000 decrease in the current cost of the bond liability. After recording these entries, the separate books of Podunk show investment in Sickle bonds and interest income of $48,000 and $3,250, respectively. The separate books of Sickle show 9% bonds payable and interest expense of $96,000 and $5,000, respectively. The working paper entry to eliminate reciprocal bond investment and bond liability amounts will be for $48,000, just as in the previous example. However, an additional working paper entry is necessary to eliminate reciprocal interest income and interest expense as follows: Interest income ( R, SE) 3,250 Interest expense ( E, +SE) 3,250 To eliminate reciprocal interest income and interest expense. This entry, which reduces the interest expense for the full amount of the intercompany interest income, results in interest expense of $1,750 ($5,000 $3,250) in the consolidated income statement for the year. The $1,750 consists of the nominal interest of $6,750 on bonds outstanding during the year [($100,000 9% M year) + ($50,000 9% M year)] less the $5,000 decline in the current cost of bonds payable. (Others may prefer to show interest expense at $6,750 and to treat the $5,000 adjustment as a separate income item.) The $5,000 decrease in the current cost consists of a $3,000 decrease in the current cost of bonds constructively retired ($50,000 $47,000) plus a $2,000 net decrease in the current cost of the bonds held outside of the consolidated entity at December 31, 2003 ($50,000 $48,000). This type of analysis would not be necessary for practical accounting applications because the $1,750 net amount of interest expense results automatically from offsetting intercompany interest income against interest expense. It makes no difference whether it is the parent company s or subsidiary s bonds that are constructively retired because the analysis and computations under the current cost system described are exactly the same in either case. ASSIGNMENT MATERIAL W 11-1 W 11-2 W 11-3 W 11-4 W 11-5 W 11-6 How are unrealized gains and losses eliminated in consolidating the financial statements of affiliated companies when current cost accounting is applied? Describe the computation of the equity of minority shareholders when a current cost system of accounting is used (assume the contemporary theory of accounting except for the application of the current cost system). How would the current cost of goodwill be determined under a current cost system of accounting? How would different transfer prices for intercompany transactions affect consolidated assets and consolidated net income under a current cost system of accounting? If a current cost system of accounting were used, would it still be necessary to eliminate intercompany sales and purchases? Intercompany receivables and payables? Discuss. Assume that Seaside Company is a 90%-owned subsidiary of Prescott and that a current cost system of accounting is applicable to the separate company and consolidated financial statements of these affiliated companies. During 2003, the following intercompany transactions took place between Prescott and Seaside: 1. Prescott sold merchandise that cost $18,000 and had a $20,000 current cost at the time of sale to Seaside for $25,000. At December 31, 2003, 25% of this merchandise with a current cost of $5,500 remained unsold by Seaside. 6 ADVANCED ACCOUNTING

7 2. Prescott acquired 10% of Seaside Company s outstanding bonds at December 31, 2003, for $99,000. The book value of Seaside s bond liability before year-end adjustments on this date was $1,000, On July 1, 2003, Seaside sold land with a book value (current cost at January 1, 2003) of $40,000 to Prescott for $50,000. This land had a current cost of $45,000 both at the time of sale and at December 31, REQUIRED 1. Prepare journal entries to record: a. The foregoing transactions for 2003 on the separate books of Prescott and Seaside. (Current cost adjustments are only made at year end.) b. Year-end adjustments on the separate books of Prescott and Seaside at December 31, Prepare the working paper entries related to the foregoing transactions that would be necessary to consolidate the financial statements of Prescott and Seaside at December 31, W 11-7 Separate financial statements on a current cost basis for Pringle and Slate at and for the year ended December 31, 2003, are as follows (in thousands): Pringle Slate Combined Income and Retained Earnings Statement for the Year Ended December 31, 2003 Sales $800 $290 Income from Slate 14 Cost of sales (695) (200) Expenses (53) (70) Net income Add: Beginning retained earnings Deduct: Dividends (30) (10) Retained earnings December 31, 2003 $251 $ 70 Balance Sheet at December 31, 2003 Cash $ 82 $ 40 Other current assets Plant assets net Investment in Slate 199 Total assets $951 $300 Liabilities $100 $ 30 Capital stock Retained earnings Total equities $951 $300 ADDITIONAL INFORMATION 1. Pringle acquired its 70% interest in Slate for $192,000 on December 31, Goodwill is not amortized. 3. During 2003, Pringle sold inventory items that cost $20,000 to Slate for $30,000. Half of these goods are inventoried by Slate at a current cost of $14,000 and are included in Slate s other current assets at December 31, REQUIRED: Prepare consolidation working papers for Pringle Corporation and Subsidiary at and for the year ended December 31, Electronic Supplement to Chapter 11 7